Managing Director & Founder of AllegisCyber Capital.
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In a previous article, I looked at the unique nature of adversary-driven innovation in the cyber market and how small, private startups are integral to creating the next-gen, over-the-horizon solutions that defend against the newest emerging threats.
These niche solutions gain traction in the marketplace and scale to the point of commodification. This forces cybercriminals to innovate on their offensive playbooks, which then calls for cyber startups to develop new defensive products, and the virtuous circle continues.
I’ve often stated that investments in cyber innovation will continue to take place, no matter the market conditions, because the stakes are too high not to.
Does this still hold true when the tech industry alone has lost over $7.4 trillion, based on the Nasdaq’s 12-month performance? When rising interest rates have put a hard stop to easy capital? When inflation has sucked the value out of future growth projections?
Sector Expertise Returns To Cyber
Venture funding hit the brakes as expected this last quarter, with Q3 2022 ending at a total of $81 billion in global venture capital investments. This was $90 billion less than last year—a 53% year-over-year reduction—according to a Crunchbase News analysis. Early-stage funding made up $34 billion of the overall total, a 39% year-over-year decrease. Series A funding fared better than Series B, down 23% year-over-year versus 54%.
Even though cyber is uncorrelated, counter-cyclical and resilient to most macro market trends, it is not completely immune from the effects of broad-market venture capital pullback. This is especially true as large amounts of capital from general tech-sector VC firms without cyber domain expertise have crept into the cyber market at increasing rates over the past few years, all chasing the promise of “alpha.”
Cyber has been thrust into the national spotlight in recent years, and interest in the market has grown in response. In 2021, cybersecurity startups raised a record-setting $29.5 billion in venture capital; everyone was keen to get in on the action.
One of the signals of VC pullback came from the Black Hat conference in Las Vegas this August. We noticed a drop in attendance this year by those generalist VC firms who had started making their rounds these past couple of years at Black Hat, RSA and other high-profile industry events.
In 2022’s uncertain economic climate, those VCs without the granular sector insight and deep domain expertise required to spot the truly disruptive companies from the “me-too” copycats have pulled back from cyber as they face increasing pressure to justify their portfolios.
This is why it’s not surprising that at $2.6 billion, Q3 2022 was the fourth straight quarter of decreased VC funding to cyber startups, the lowest quarter since Q3 2020’s $1.6 billion, according to Crunchbase data. Many investors realized that investing in cyber isn’t a part-time endeavor.
Does that mean cyber innovation is slowing down? Far from it.
Why Less Is More In Cyber
Valuation is tied to the relationship between the supply and demand of capital. When there is excess supply, two results are inevitable: Valuations get bid up, and startups that don’t meet the metrics required to be venture-financeable get funded.
Having spent over 25 years in venture capital, I’ve seen history repeat itself, and every 10 or 15 years, the market seems to find itself in a state of irrational exuberance.
Now that the market is in correction mode, valuations and expectations are being tempered, and the restriction of capital is bringing a much-needed period of time to refocus, recalibrate and reallocate.
Many sectors in cyber have become overcapitalized, letting far too many unremarkable companies suck up human and capital resources.
Investing Smart In Cyber
Demand for cybersecurity solutions remains strong: 55% of cybersecurity professionals anticipate their companies’ cyber budgets to increase in 2023, according to a recent ISACA survey. Portions of those budgets are going to go to cyber startups that will solve problems we don’t know we have yet.
The people still at the cyber party right now making new investments while the others have gone home are the hyper-focused, dedicated cyber-VC firms that are entrenched in the industry and operate with:
• Technical knowledge. Cybersecurity lives at the bleeding edge of technology. Failure to grasp an important concept and its practical applications can lead to investments in superseded technology or a substandard solution that will fail to gain and maintain market traction.
• Fast change. From ransomware gangs to nation-state actors, the threat landscape is undergoing constant change. Investors must understand the current environment and how a company’s offering and positioning will respond as the risks and landscape evolve.
• Domain expertise. There is no shortage of companies in every sector of the cybersecurity marketplace. Determining which company can establish and dominate in its sector requires deep domain expertise.
• Future vision. This includes the ability to see the evolution of the cyber threat landscape through time and anticipate where the next big waves of innovation will be required.
Is cybersecurity headed for the same market fate as the larger tech industry? Hardly. According to Momentum Cyber, this year’s year-to-date VC financing volume hit $16.5 billion at the end of Q3, which is already 54% higher than 2020’s total of $10.7 billion private equity and VC funding. According to Gartner, organizations will spend $188.3 billion on information security and risk management products and services in 2023 and grow to $262 billion in global spending in 2026.
Though the quantity of early-stage deals may go down for a period of time, I believe the quality of deals will rise. The industry’s next big investment opportunities will get their start today, in response to next-generation threats, in the midst of this down market.
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